“Lawless Capitalism Grips Russian Business”                                    “Lawless Capitalism Grips Russian Business” - The Washington Post November 7, 2000

The Political and Economic Consequences of a Corrupt Privatization The Creation of the Rule of Law and the Legitimacy of Property Rights: The Political and Economic Consequences of a Corrupt Privatization Presentation by Karla Hoff based on joint paper with Joseph E. Stiglitz November 2005

The Questions What are the dynamics of the transition to the rule of law? What actions will expedite the process? Adam Smith: argued that the creation at the end of the feudal period of opportunities to invest beyond one’s own estate engendered a new set of political interests that brought about a slow improvement in institutions. Could mass privatization in transition economies play the same role? What effect does lack of a consensus about the legitimacy of property rights have? (question applies to Russia, Zimbabwe, and other post-colonial countries)

The Hope “Privatization offers an enormous political benefit for the creation of institutions supporting private property because it creates the very private owners who then begin lobbying the government...for institutions that support property rights.” Murphy-Shleifer-Vishny 1998

 The Result in Russia Broad private ownership [didn’t create] a constituency for strengthening and enforcing [the new Civil and Commercial Codes]. Instead, company managers and kleptocrats opposed efforts to strengthen or enforce the capital market laws. They didn’t want a strong Securities Commission or tighter rules on self-dealing transactions. And what they didn’t want, they didn’t get. Black et al. 2000

Distribution of transition countries and all countries, by their World Bank rule of law scores, 1996 and 2004. .6 Transition countries 1996 .6 2004 Transition countries .4 .4 kdensity rl kdensity rl .2 .2 World World -2 -1 1 2 -2 -1 1 2 Rule of law score Rule of law score

The “no-rule-of-law state” in Russia in the 1990s “a wild market outside the law” “a systemic vacuum …without effective regulations and controls” “a robber-anarchical form of capitalism”

Elements of a model and outline of talk: Legal Transition as a Markov Process 2 states of the world, rule of law (L) and non-rule of law (N) Probability of transition to rule of law depends on votes in the current period of those with control rights over assets xt vote against 1-xt vote for. Suppose the rule of law is pareto efficient and so is an absorbing state Then a path is: N N N L L L LLLLLLLLLL… The model can address the question: How long will it take before the transition to rule of law (state L)? Outline of talk: 1. Example of a static coordination game 2. Dynamic model, in which we consider equilibria in which x is the same each period as long as state N lasts 3. Limitations/extensions of the model

1. One period coordination game Agent Strip assets Build value Political environment No rule of law 1/4  (distribution of stripping abilities among agents) Rule of law 1 Lesson: payoff from building value depends on constituency for creation of rule of law

Question: Could individuals choose the “wrong” rules of the game? In choosing his economic action, each individual ignores the effect of his economic decision on how other people believe the system will evolve and, thus, how others invest and vote.. Each individual votes his self-interest

Example Stripping returns uniformly distributed on [0,1] = (1-x)2 Probability of rule of law = demand “squared”

Illustration of example: Payoffs under non-rule of law state (some agents strip, others build) and payoffs under rule of law (all agents build) Rule of law No rule of law Agents obtain payoffs from ¼ to 1 depending on stripping ability All agents obtain payoffs = 1

Unique stable equilibrium, probability of rule of law = 1/9 Switch line: *= ¼ + ¾ (1-x)2 Unique stable equilibrium, probability of rule of law = 1/9 Payoffs 1 1/4 Stripping ability curve: x = 1 -  2/3 x 1 Increasing support for the rule of law In this ex., switch line

Unique stable equilibrium, probability of rule of law = 1/9 Switch line: *= ¼ + ¾ (1-x)2 Unique stable equilibrium, probability of rule of law = 1/9 Payoffs 1 1/4 Stripping ability curve: x = 1 -  2/3 x 1 Increasing support for the rule of law In this ex., switch line = expected return from building value

2. Legal Transition as a Markov Process Probability of transition to rule of law depends on votes in the current period xt vote against 1-xt vote for. We explore a subset of possible equilibria where, as long as the no-rule-of-law prevails, the demand is the same every period. The rule of law is an absorbing state. So a path is: N N L L L L L L L…..

Technology and payoffs DEPLETION OR GROWTH OF ASSET FLOW STRIP s N ( q ) = q s L ( q ) = q [ 1 - l ] BUILD b j = f – I j with

Switch line for building value vs. Economic and political behavior are linked Switch line for building value vs. stripping .

The switch lines in the non-rule-of-law state θ II (strip assets and oppose establishment of the rule of law) θp(x;λ) III (strip assets and demand the rule of law) I (build value and demand the rule of law) θa(x;λ) x 1 Increasing opposition to the rule of law

The switch lines, numerical example θ 1.2 θa(x;0.3) II 1 θp(x;0.3) 0.8 0.6 III 0.4 I 0.2 0.2 0.4 0.6 0.8 1 x

The effect on the switch lines of a fall in λ θ 1.2 θa(x;0.3) 1 II θp(x;0.1) 0.8 θa(x;0.1) θp(x;0.3) 0.6 III 0.4 I 0.2 0.2 0.4 0.6 0.8 1 x

Two stable equilibrium values of x* θ 1.2 θa(x;0.3) 1 θp(x;0.3) 0.8 Stripping ability curve 0.6 0.4 θa(x;0.3) 0.2 x*=0 x*=0.75

Two stable equilibrium paths of agents’ aggregate expected income 2.5 2.0 x* = 0 1.5 Agents' aggregate expected income 1.0 x* = 0.75 0.5 10 20 30 40 50 60 70 80 Time period

Why can’t society “grandfather” the control rights of the asset strippers? Dynamic consistency problem-- The security of such rights depends on the social consensus that underlies them. Not just any distribution of property can be protected under the rule of law.

λ = 0 (no reappropriation of stripping returns) θ 1.2 II 1 θmax θp(x;0) 0.8 III 0.6 I 0.4 0.2 θa(x;0) 0.2 0.4 0.6 0.8 1 x

. Presence of a minority of agents for whom stripping always dominates building value will amplify the coordination problem among agents for whom rule of law is the pareto efficient state θ 1.2 Stripping ability curve 2 1 θa(x;0.3) θp(x;0.3) 0.8 Stripping ability curve 1 0.6 0.4 0.2 x*=0.85

To sum up: Functionalist arguments may be misleading 1. The political environment is a public good 2. Actions have spillover effects on the political environment, which may put in place forces that delay the establishment of rule of law i’s action vote j’s action vote

Trade-offs in the choice of reform sequences Decay of state assets Y = constant Big bang is preferred Gradualism is preferred Leftward shift in stripping ability curve

3. Caveats: The process of legal regime transition may not be Markov History affects norms “Vladimir Rushaylo has flatly denied the allegations that 70 per cent of all Russian officials are corrupted … ‘Only those who have links with the organized criminal gangs can be regarded as corrupted officials. Do not mistake bribe-taking for corruption,’ the Russian Interior Minister stressed.   (BBC, March 13, 2001)

History affects the distribution of wealth and power Muckraking Governor Slain By Sniper on Moscow Street Wall Street Journal, October 19, 2002

Conclusion Coasian view (what matters is defining property rights) is misleading, because it ignores the problem of corporate governance (the control function in corporations is not allocated on the basis of property rights) and the resulting scope for theft In Russia, privatization occurred prior to the creation of the rule of law—or of a government with political legitimacy—and the long run prospects of rule of law may have been undermined Similar problems of legitimacy and rule of law have bedeviled countries where a legacy of colonial rule is a set of weak and conflicting property rights institutions and patterns of authority

Zimbabwe—2000 When land-hungry citizens in Zimbabwe seized control of large, privately owned, commercial farms in 2000, “the courts and the international media [interpreted this] as a battle over ‘the rule of law,’ but the crisis quickly expanded to a debate over the history of racial domination and the legitimacy of inherited laws and institutions…Responding to international pressure that land reform must proceed within the law, Zimbabwean activists and intellectuals replied that [the distribution of property rights ] was an artifact of colonial rule…Today, they point out, it is illegal in Zimbabwe to possess stolen property. So who is subverting the rule of law?”